The Moral Hazard Problem in Hedge Funds: A Study of Commodity Trading Advisors

Abstract

The asymmetric nature of performance-based compensation in hedge funds introduces a moral hazard problem in which investors bear the negative consequences of fund managers’ risk choices. In this article, the authors analyze whether risk shifting by a hedge fund manager is related to the manager’s investment strategy and survivorship concerns. Using gross fund returns from 1994 to 2014, the authors find that the tendency to increase risk following poor performance is weak (strong) when there are strong (weak) managerial survivorship concerns. At the same time, risk shifting is significantly less prevalent when a manager uses algorithms, instead of discretion, in an investment strategy. The authors introduce a new model for estimating the economic impact of risk shifting on hedge fund managers and investors. They estimate that fund managers generate an additional 0.25% per annum in fees that negatively impact investors’ risk-adjusted returns.